Real GDP growth in the developing countries is expected to remain relatively buoyant at
slightly over 6 percent in 1997 and similar growth is projected for 1998. While the rapid
expansion in the Asian region is projected to moderate somewhat further, many countries in
other regions that saw a marked strengthening of activity in 1996 are expected to sustain this
improvement in the period ahead. In most developing countries, low or declining inflation
and generally prudent fiscal policies suggest that threats to growth arising from policy
imbalances have been significantly reduced. However, in a number of cases, large external
imbalances and fragile banking systems have emerged and have affected investor confidence.
These problems typically underscore both the presence of downside risks to the near-term
growth outlook and the desirability of some cooling off of domestic demand pressures as well
as the need for financial sector reforms. Provided macroeconomic stability is not jeopardized
and the necessary reforms are implemented without undue delay, such short-term difficulties
should not significantly affect the generally positive long-term prospects of these
countries.

In the Western Hemisphere, both Argentina and Mexico have continued to
recover following the 1995 crisis, and growth is expected to remain fairly strong during the
period ahead. While Argentina is enjoying virtual price stability, Mexico’s inflation
rate will need to be reduced further through the pursuit of prudent fiscal and monetary
policies; the adoption of additional structural reforms to foster saving and investment would
also help ensure the sustainability of the expansion. Venezuela has also experienced a
welcome turnaround following a drop in output in 1996 but inflation remains stubbornly high
and the authorities will need to press on with continued reforms to strengthen performance of
the non-oil sector.

In Brazil, inflation has continued to abate and is expected to fall below 8 percent in
1997, but the external deficit has been rising. A further tightening of the fiscal stance is
needed to better balance the policy mix, reduce interest rates, and maintain market
confidence. In Chile, growth and inflation have slowed somewhat as a result of
measures to address the risk of overheating; healthy fundamentals point to continued
medium-term growth in the range of 6 to 7 percent. While Chile’s economy remains
the strongest among the developing countries of the Western Hemisphere, there are
encouraging signs that improved macroeconomic discipline and intensified structural reform
efforts are improving the growth outlook for other countries in the region.

In Asia, despite the region’s impressive growth performance in recent years, several
countries have recently experienced financial market pressures linked to concerns about large
external deficits; in many cases, currencies linked to the appreciating U.S. dollar have
aggravated the tensions. The pressures have been most acute in Thailand, where
fragilities in the banking system contributed to market concerns. After a series of attacks on
the baht, a more flexible exchange rate regime was introduced in early July and there has
since been a depreciation of over 30 percent vis-à-vis the U.S. dollar. Provided
adequate measures are adopted to strengthen the financial sector and the balance of payments,
confidence should be restored relatively quickly. Growth in Thailand is likely to
slow significantly in the short run but should subsequently return to its quite strong
longer-term trend. Spillovers from the crisis in Thailand were felt by several countries in the
region, especially the Philippines, Indonesia, and Malaysia. In these countries,
which are also likely to experience an economic slowdown in the near term, the authorities
will need to contain external deficits and reduce the reliance on foreign borrowing in order to
restore investor confidence. Following a fairly widespread slowdown in foreign demand in
1995–96, most of these economies have experienced a pickup in exports in the first
half of 1997, in line with the general strengthening of world industrial activity and trade that
began in the middle of 1996.

The soft landing of China’s economy has succeeded in alleviating inflationary
pressures: consumer price inflation is expected to moderate to 4½ percent in 1997, a
striking contrast with the 22 percent inflation rate registered in 1994. At the same time,
growth has been maintained at over 9 percent, which seems to be close to China’s
potential growth rate. However, sustaining such rapid growth with low inflation will require
restructuring and efficiency improvements in state enterprises (including through diversifying
ownership), financial sector reforms, and a strengthening of budget revenues. The strong
balance of payments position provides an opportunity to accelerate trade liberalization, which
is also critical for China’s longer-run growth prospects. Annex I discusses longer-term
trends and policy challenges in China in greater detail.

Relatively solid growth is also projected to continue in India even though the pace of
catch-up with advanced economy living standards remains substantially slower than in China
and below what India should be able to achieve. The reform process under way since 1992
has already produced notable results, raising annual growth to about 7 percent since 1994
compared with about 5 percent through the 1980s and early 1990s. But stronger efforts are
needed to reduce the large fiscal deficit, which remains a risk factor for inflation and a
constraint on growth. Further trade and capital account liberalization, deregulation of
domestic product markets, and enterprise and financial sector reform are also needed to put
India on a steeper sustainable growth path. In Pakistan, following severe balance of
payments difficulties in late 1996, there is a continued need for strong stabilization measures
to accompany the recent introduction of wide-ranging structural reforms.

Developing countries in the Middle East and Europe region have witnessed significant
improvements in economic performance in recent years and average growth is expected to
continue in the 4 to 5 percent range in 1997–98 despite a slight decline in oil prices. In
Egypt, efforts to reduce inflation and strengthen the fiscal position together with
extensive structural reforms have noticeably enhanced growth performance and the outlook.
Jordan continues to reap the benefits of comprehensive policy reforms as underscored
by robust economic growth, low inflation, and declining internal and external imbalances.
Growth prospects have also improved for the Islamic Republic of Iran,
assuming that broad-based structural reforms are introduced. Growth in Turkey has
been stronger than expected but the persistence of large fiscal imbalances and very high
inflation is unlikely to be compatible with sustained growth.

For Africa, the overall growth estimate for 1997 has been revised down to 3¾ percent
compared with 4½ percent in the May 1997 World Economic Outlook. The
downward revision appears disappointing following the relatively encouraging outcome for
1996. However, this result is strongly influenced by developments such as drought in
Morocco and civil war and political turmoil in the Democratic Republic of the
Congo and the Republic of the Congo. Elsewhere in Africa, many countries
continue to benefit from the implementation of stronger macroeconomic and structural
policies. For example, CFA franc zone countries such as Côte
d’Ivoire, Mali, and Senegal are seeing continued recovery
following the exchange rate adjustment in 1994 and accompanying policies. Botswana,
Malawi, and Uganda are also enjoying robust growth as a result of
market-oriented reforms and greater macroeconomic discipline, together with improved
weather. South Africa’s growth has not yet responded to the authorities’
policy reforms, and activity is expected to slow somewhat in 1997. However, with continued
reform efforts, and the return of investor confidence, the outlook has begun to improve.
Nigeria’s economic performance remains disappointing and the outlook
uncertain due to persistent weaknesses in macroeconomic and structural policies. In
Algeria and Tunisia, significant progress with privatization and structural
reforms is expected to support continued growth at around 5 percent. Overall, while
the fragility of Africa’s recovery is highlighted by recent setbacks and political
uncertainties, there are also a significant number of relatively successful economies that
illustrate the region’s potential for reversing the long-run decline in living standards
during much of the past quarter century. In 1998, growth in Africa is projected to recover to
about 5 percent.

The weight of developing countries in the global economy is increasing rapidly (Figure 3). At the same time their growing integration into world financial
markets poses significant challenges. Capital inflows, particularly of foreign direct
investment, can substantially enhance countries’ growth performance. However, there
is also a risk that large capital inflows may become a substitute for domestic saving,
contribute to overheating, result in excessive current account deficits, and strain the capacity
of inadequately developed financial systems and the supervisory framework. While rapidly
growing economies can often sustain relatively large external deficits for a period when the
associated capital inflows are invested productively, experience shows that persistently large
deficits are likely sooner or later to result in highly disruptive changes in market sentiment.
Previous World Economic Outlook reports have discussed extensively the policy
requirements for minimizing such risks, notably the frequent need to strengthen fiscal policy
(even though the fiscal situation may be sound), and the need for prudential rules that limit
the banking system’s exposure to domestic loan problems and to foreign exchange and
liquidity risks.4 In addition, a gradual introduction of
capital account convertibility would allow domestic investors greater opportunities to
diversify their portfolios and help alleviate potential pressures on domestic asset prices.

The serious consequences of a significant shift in market sentiment have been underscored by
the financial crises that have engulfed much of Southeast Asia in recent months. A number of
factors explain the emergence of speculative pressures in Thailand. The combination of a
rising real effective exchange rate and a large current account deficit heightened the
perceived risk of a crisis and prompted concerns about international competitiveness.
Moreover, heavy reliance on external borrowing (denominated in foreign currency) increased
the economy’s exposure to exchange rate risk and perceived vulnerability to a sudden
reversal of capital inflows. Also, and perhaps most important, there were serious fragilities in
the financial sector (especially among Thai finance companies), linked in part to previous
rapid growth in property-based lending, unhedged corporate foreign-currency indebtedness,
and the economic slowdown. Finally, as these problems became more apparent and more
widely perceived in financial markets, and as the need for decisive corrective action
accordingly became more pressing, the initial response of the authorities did not allay
growing concerns in financial markets. The result is a crisis that is deeper and more
widespread than would likely have occurred if adequately forceful action had been taken at an
earlier date. Indeed, the problem of confidence linked to much of the decline in
Thailand’s official reserves and the incurring of large volumes of forward contracts in
foreign exchange probably could have been avoided or significantly alleviated if the present
stabilization program had been put in place this spring.

On the other hand, it does appear that private financial markets may have a tendency to react
too late to prevent a costly adjustment, and then to overreact, when a country is beset by
problems that turn into a foreign exchange crisis and related economic difficulties and when
the full extent of these problems becomes apparent. In the case of Mexico, for example, the
private market continued to channel large inflows of capital well into 1994 and then,
following the December 1994 devaluation of the peso, underwent a collapse of confidence
that led to massive nominal and real depreciation and very high levels of domestic interest
rates. Concerns about the Mexican authorities’ ability to implement a strong
adjustment program, as well as the incomplete provision of data prior to the crisis,
contributed to this adverse result. However, two and a half years later, it seems clear that the
collapse of market confidence in Mexico was overdone. Unfortunately, the Mexican
economy has probably suffered a more painful correction than was truly needed on the basis
of an objective assessment of its economic situation and capacity for successful policy
adjustment. Spillover effects to other economies in the region in 1995 also now appear to
have been overdone. The international community was surely right to signal forcefully its
support for Mexico’s stabilization efforts and thereby to help to avoid larger
unnecessary losses for Mexico and for other countries.

Similarly in the case of Thailand, now that the Thai authorities have committed themselves to
a strong adjustment program, the international community has provided its substantial
endorsement. Adjustment is needed and is under way, and although economic difficulties will
continue in the months immediately ahead there should be confidence that Thailand will
gradually return to its characteristically strong economic performance.

A key lesson from these episodes is that even if markets on occasion may appear to overreact,
at least when viewed with hindsight, investors may well be acting in a prudent manner,
particularly when governments initially ignore the signals that markets provide. Indeed,
markets clearly have a useful role to play in alerting governments to the need for timely
action, and their strong reaction may be necessary to focus the attention of policymakers on
the need for corrective measures. This further underscores the need for policy discipline to
avoid adverse and costly market reactions.

As in the case of Mexico, developments subsequent to the recent floating of the Thai baht
demonstrated the tendency for a crisis in one country to have spillover effects on other
countries where similar risk factors are perceived by financial markets as being present. But
while there are some parallels between Thailand and other east Asian countries, there are also
some important differences. In particular, the economic fundamentals in Indonesia, Malaysia,
and the Philippines were generally stronger than those in Thailand at the time of the crisis.
While the Thai devaluation would imply a worsening of the competitive position of some of
its neighbors, in terms of economic fundamentals, the extent of spillover effects would
appear to be excessive even though policymakers need to make sure that economic
weaknesses and fragilities are not left unaddressed. Overall, there are reasons to believe that
the currency turbulence will eventually wane without greatly damaging the region’s
long-term prospects.

Recent events have also focused attention on the role of the exchange rate regime in
developing countries. Since the 1970s, there has been a gradual but significant shift toward
more flexible exchange rate arrangements. In a few cases, the authorities have opted for even
greater fixity of their exchange rates than under the Bretton Woods regime of fixed but
adjustable parities through the adoption of currency boards (as in Argentina and Hong Kong,
China). More generally, countries have tended to move away from the pegs they originally
adopted after the industrial countries switched to floating rates in the early 1970s, and have
instead introduced arrangements that allow more frequent adjustments, such as exchange rate
bands (with crawling central rates), managed floats, or floating exchange rates. In virtually all
of those cases, however, the exchange rate appropriately remains a key concern of economic
policy, with policy adjustments often being undertaken to limit exchange rate volatility.

Contrary to what might have been feared, the switch to more flexible exchange rate
arrangements has not in general been associated with higher inflation. Although fixing the
exchange rate to hard currency pegs (or a currency board) has often been an essential element
in disinflation strategies, once the domestic sources of inflation—typically lax fiscal and
monetary policies—have been brought under control, increased flexibility in exchange
rate management appears in practice not to weaken macroeconomic policy discipline and
may well be more helpful in the face of external shocks that require domestic policy
adjustments. Indeed, while there are many examples of pegged exchange rate regimes
functioning reasonably well for extended periods, there are also numerous examples of
pegged exchange rates being adjusted too late in the face of capital inflows that ultimately
proved destabilizing. Greater willingness to let the exchange rate move in response to
changing circumstances may also help convey a more realistic perception of risk to both
domestic and foreign investors. Nevertheless, despite the potential advantages of more
flexible exchange rate regimes in dealing with balance of payments pressures, such regimes
pose other challenges, especially the need to limit excessive exchange rate volatility.

4The need for an international banking standard applicable
to both advanced and emerging market countries, particularly for internationally active
financial institutions, has received considerable attention since the Mexican crisis in
1994–95. Substantial progress has now been made in formulating such a standard,
which would include the "Core Principles for Effective Banking Supervision"
recently put forward by the Basle Committee on Banking Supervision. See also David
Folkerts-Landau and Carl-Johan Lindgren, Toward a Framework for Financial Stability
(Washington: IMF, forthcoming).